Person associated with member firm engaged in private securities transactions without prior written notification and approval. Held, association's findings of violation and sanctions it imposed are sustained.

Appearances:

David A. Genelly, John C. Corrigan, and James E. Judge, of Vanasco, Genelly & Miller, for Frank Thomas Devine.

Jeffrey S. Holik and Norman Sue, Jr., for NASD Regulation, Inc.

Appeal filed: June 15, 2001
Last brief received: October 12, 2001

I.

Frank Thomas Devine, formerly employed as an investment company and variable contracts products representative with U.S. Life Equity Sales Corp. ("U.S. Life Equity"), a member of the National Association of Securities Dealers, Inc. ("NASD"), appeals from NASD disciplinary action. The NASD found that Devine engaged in private securities transactions without giving prior written notice to U.S. Life Equity in violation of NASD Conduct Rules 3040 and 2110.1 It fined Devine $34,825.42, suspended him for 90 days from association with any NASD member in any capacity, required him to requalify by examination as an investment company and variable contracts products representative, and assessed costs against him. We base our findings on an independent review of the record.

II.

From September 1996 through April 1997, Devine was registered with U.S. Life Equity, which is a subsidiary of U.S. Life Corporation ("U.S. Life Corp."). During this period, Devine also was retained by U.S. Life Corp.'s insurance subsidiary, All American Life Insurance Company ("All American"), as a non-exclusive sales agent.

On January 29, 1997, All American issued a bulletin (the "Bulletin") to its insurance agents, including Devine, regarding its disapproval of sales of viatical settlements.2 Devine contacted John Champion, a vice president of marketing at All American, who confirmed that All American agents could not sell viatical settlements to individuals who were All American customers. Devine testified that he believed that the Bulletin permitted him to sell viatical settlement products to persons who were not All American customers. He also claimed that he thought the viatical settlements were an insurance product because All American, the insurance subsidiary -- not U.S. Life Equity, the broker-dealer -- had issued the Bulletin.

According to PCO's materials, under the PCO program customers executed agreements loaning funds to PCO for a 12-month period. Customers were to receive a rate of return on their loans that varied between 21% and 25%, paid semi-annually. The customers' funds were to be pooled and deposited in an escrow account, maintained by Escrow Plus, Inc. (PCO's escrow agent) at a California bank. PCO was to identify paid-up insurance policies of terminally ill persons available at a discount, and use the pooled deposits to purchase the policies. All of the insurance policies purchased by PCO were to be held in escrow as "collateral" for the loans. Upon the death of the insured, the death benefits were to be paid to Escrow Plus and pooled in the escrow account. The return on the loans was to be paid from the proceeds of the insurance policies when the terminally ill persons died.3

Over the next few weeks, Devine conducted a number of Internet searches for information about PCO and viatical settlements. He contacted the Better Business Bureau, the California State Department of Corporations, the National Association of Viaticals, and the American Association of Viaticals regarding PCO and Escrow Plus. Devine determined that PCO had a pending membership application with the American Association of Viaticals, and that, at that time, there were no complaints regarding PCO or Escrow Plus.

On February 10, 1997, Devine executed an agent commission agreement with M.D. Smith to "endeavor to find [l]enders for PCO" for a five-percent commission "on the [l]ender's deposit." On February 22 and 23, 1997, Devine attended a meeting organized by PCO in Denver, Colorado. At the meeting, Devine met David Laing, the president of PCO, Valerie Jenkins, the president of Escrow Plus, Michael Smith of M.D. Smith, and other PCO salespersons. PCO salespersons reported that their clients who loaned money to PCO had received their semi-annual interest checks on time. Devine admitted that participants at the meeting repeatedly raised the question of whether the PCO instruments were a security. PCO's general counsel and other PCO personnel claimed that the PCO notes were not securities, citing the Court of Appeals decision in Life Partners.4 Devine spoke directly to PCO's general counsel, who reiterated that the instruments were insurance products and not securities. Devine also reviewed a letter from another attorney to PCO's former marketing agent opining that the PCO notes were not securities.5

Devine admits that, from late February to March 1997, he solicited five customers who invested $898,749.50, resulting in commissions to him of $19,661.92.6 Devine also admits that he did not notify U.S. Life Equity of his activities, although U.S. Life Equity's procedures notified him that he needed to seek the firm's written prior approval before engaging in private securities transactions.

On April 2, 1997, shortly after Devine began selling the PCO instruments, federal prosecutors in the Southern District of New York filed a criminal complaint against Laing and three others involved in PCO, alleging that they fraudulently induced more than 950 investors to invest in the PCO instruments.7 On April1997, Devine discovered that some of PCO's officers, including Laing, Jenkins, and Smith, had been arrested for fraud. Devine, Blake, and a third All American salesman, Timothy Fergus, attempted to stop their customers' payments to PCO. Devine contacted an attorney at the California Department of Corporations, who requested that Devine prepare a letter estimating the amounts invested, which Devine sent. Devine subsequently assisted his customers in filling out claim forms for the PCO receiver.8

III.

Conduct Rule 3040 provides that no person associated with an NASD member firm "shall participate in any manner in a private securities transaction" unless the person has first provided written notice to the member firm with which he or she is associated "describing in detail the proposed transaction and the person's role therein and stating whether he has received or may receive selling compensation in connection with the transaction . . . ." Rule 3040 defines a "private securities transaction" as "any securities transaction outside the regular course or scope of an associated person's employment with a member, including, though not limited to, new offerings of securities which are not registered with the Commission." Devine argues that the PCO instruments were not securities.

Section 2(1) of the Securities Act of 1933 and Section 3(a)(10) of the Securities Exchange Act of 1934 generally define a security to include "[a]ny note."9 Regardless of whether an instrument is specifically labeled as a "note," if it evidences a promise to pay a specified sum of principal and interest to the payee at a specified time or on demand then it meets the description of a note.10 The PCO instruments evidenced a promise to pay a specified sum of principal and interest to the payee at a specified time and, thus, were notes.

Congress intended that the definition of "security" should be interpreted broadly.11 In determining whether a note is a security, the Supreme Court, in Reves v. Ernst & Young, adopted a "family resemblance" test.12 The "family resemblance" test presumes that a note is a security unless: (1) it bears a strong resemblance to certain types of notes recognized, based on four factors identified by the Court, as being outside the securities market regulated under the federal securities laws, or (2) a balancing of the same four factors leads to the conclusion that it should be added to the list of notes that are deemed not to be securities.13 The four factors to be considered are: (1) the motivations that would prompt a reasonable seller and buyer to enter into the transaction;14 (2) the "plan of distribution" of the instrument;15 (3) the investing public's reasonable expectation that the note is a security;16 and (4) whether some factor, such as the existence of another regulatory scheme, significantly reduces the risk of the instrument, thereby rendering application of the federal securities laws unnecessary.17 Thus, the presumption that a note is a security can be rebutted only when the analysis, based on all the evidence, leads to the conclusion that the note is not a security.18

Applying the test set forth in Reves, we find that the notes Devine sold are securities. As an initial matter, we find that the PCO notes do not resemble those notes excluded from the definition of a security.19 Devine argues that the PCO notes are similar to the particular types of secured notes excluded from the definition of security because collateral, i.e. the insurance policies, allegedly supported the underlying debt obligation. Devine does not explain how the PCO notes resemble those notes or how a security interest in the insurance policies was established, except to cite generally PCO's marketing package. That package includes certain form contracts. None of those contracts purports to establish a lien or security interest in the insurance contracts. The Lender Agreement between the customer ("Lender") and PCO states, "Lender shall not have the right, at any time, to withdraw funds from the escrow." The only reference to collateral is in a form Escrow Agreement among the Lender, Escrow Plus, and PCO. That agreement states that "all purchased policies are pooled and held as collateral in the Escrow." The idea that this sentence somehow creates a security interest in those policies in favor of any particular Lender is contradicted by the immediately proceeding sentence, which states, "Lender is not tied into a specific policy purchase."

Moreover, under the form agreement contained in the marketing package by which the insured sold his or her policy, the purchaser was Laing, individually, not PCO. Thus, PCO's own documents raise a question whether PCO would own the insurance contracts, let alone have the power to grant a secured interest in such a contract.20

Balancing the four factors identified in Reves, we conclude that the PCO notes should not be added to the list of notes excluded from the definition of securities. Turning to the first of the Reves "family resemblance" factors -- the motivations that would prompt a reasonable seller and buyer to enter into the transaction -- PCO entered into the transaction to raise working capital for its business of purchasing insurance policies. Although the line between commercial and investment uses may not always be sharp, the Reves' examples do not suggest the exclusion of notes that fund the enterprise generally.21 Because the purchase of viatical insurance contracts was at the core of PCO's business, its use of investors' money to buy these contracts is appropriately viewed as a general business use. The investors loaned the money to PCO with the expectation of profit based on the 21% to 25% interest rates purportedly offered.22 Thus, the first Reves factor supports finding that the PCO notes are securities.

We find that the second factor -- the plan of distribution of the notes -- also supports the conclusion that the notes are securities. The Reves court held that offer and sale to a "broad segment of the public" establishes the requisite common trading in an instrument.23 According to PCO's receiver, PCO's sale of the notes raised approximately $90 million from more than 1,500 investors across the country. It is, therefore, clear that the notes were broadly distributed.

The reasonable expectations of the investing public as to whether the instruments were securities also support finding that the PCO notes are securities. While it is true that PCO required its investors to acknowledge that a PCO note was "not an investment as defined by the Securities and Exchange Commission," the record demonstrates that the PCO investors reasonably understood that the notes were "investments."24 The PCO marketing materials highlighted the notes' "attractive rates of return," and PCO's plans for growth and expansion. In his testimony, Devine referred to the loans as "investment money," using the term "to invest" in connection with making loans to PCO, and detailing how his clients "invested . . . risk capital" in the notes.25

There is, moreover, no alternative scheme of regulation or other factor that significantly reduces the risk of the instrument so as to make regulation under the federal securities laws unnecessary. Thus, the fourth Reves factor supports finding that the notes were securities.

Devine argues that, in Life Partners, the court determined that non-recourse promissory notes issued by a viatical settlement company to customers' IRA accounts were not securities.26 The court's conclusion in Life Partners rested on its earlier finding that "the underlying viatical contracts [issued by Life Partners] are not securities."27 The court found that Life Partners issued the notes "merely in order to navigate around certain restrictions in the tax code that preclude IRAs from investing in life insurance contracts," and their existence did "not alter the substance of the transaction in any manner that would suggest a role for the securities laws that is not otherwise indicated by law."28

In Life Partners, the investors received directly or through the non-recourse notes fractional interests in insurance policies. In contrast, PCO investors executed loan agreements to provide PCO with funds "for the purpose of carrying out its business," and not, as in Life Partners, to purchase interests in particular insurance policies. Indeed, the PCO escrow agreement made clear that the Lender "[was] not tied to a specific policy purchase." The PCO notes offered a fixed rate of return that, unlike Life Partners, was neither adjusted nor modified as a result of the death of a particular insured or the receipt of the proceeds from a particular policy.29

We find that, based on the above four factors, the PCO note does not resemble one of the enumerated types of notes excluded from the definition of a security. We also find that under the second step of the analysis -- whether the note should be added to the list of excluded notes, based on a balancing of the four Reves factors -- the four factors weigh heavily against the creation of a new category of note outside the protection of the federal securities laws. Accordingly, we find that the PCO notes constitute securities under Reves and that Devine's participation in the PCO transactions violated NASD Conduct Rules 3040 and 2110.30

IV.

Exchange Act Section 19(e)31 provides that we will sustain the NASD's sanctions unless we find, having due regard for the public interest and the protection of investors, that the sanctions are excessive or oppressive or impose an unnecessary or inappropriate burden on competition.32

Devine asserts that, while requiring him to requalify as an investment company and variable contracts products representative is "the proper remedial requirement to counteract future lack of awareness on [his] part," the suspension and fine imposed by the NASD are excessive.33 He argues that the NASD failed to consider various factors that, in Devine's view, mitigate his conduct.

Devine notes that the NASD's Sanctions Guidelines state that the NASD may consider "[w]hether the respondent demonstrates reasonable reliance on competent legal" advice.34 Devine argues that he reasonably relied on the advice of counsel that the PCO instruments were not securities. We do not believe Devine's reliance was reasonable. Devine asserts that PCO gave him an opinion of counsel addressed to its former marketer that the instruments were not securities, which opinion was confirmed by PCO's general counsel at the PCO meeting in Denver. However, we have warned that a registered representative cannot rely on issuer's counsel to determine whether an instrument is a security.35

Devine relies on a conversation that Blake had with Blake's neighbor, an attorney, in which the neighbor agreed with the opinion letter. We believe that this conversation does not aid Devine. Blake's neighbor testified that he had no attorney-client relationship with Blake and never discussed the lawfulness of the PCO instruments with Devine. Devine further cites an opinion letter sent to another person and dated at the end of March 1997, which Devine apparently received at the beginning of April. Since this letter was dated after Devine's transactions and was not addressed to Devine, we agree with the NASD that Devine could not have relied on that letter.

Devine asserts that he investigated the merits of the PCO program and that his clients were wealthy and sophisticated. However, Conduct Rule 3040 focuses on the obligation of the associated person to give notice to his or her member firm. Devine's attempts at an investigation or the sophistication of Devine's customers do not change that obligation. As we have held on numerous occasions, Rule 3040 is designed not only to protect investors from unmonitored sales, but also to protect securities firms from exposure to loss and litigation in connection with sales made by persons associated with them.36

Moreover, Devine knew, based on his attendance at the sales meeting, that whether the PCO program was a security was an issue. U.S. Life Equity's procedures made clear that, if the question of whether an instrument was a security arose, the associated person should contact U.S. Life Equity. Devine failed to follow that step.

Devine argues that other factors mitigate his conduct. Devine did not have a proprietary or beneficial interest in PCO, did not give the impression that All American or U.S. Life Equity sanctioned the sale of the PCO instruments, and did not sell notes to U.S. Life Equity customers -- all factors identified by the NASD Sanctions Guidelines as mitigative.37 Devine also notes that he helped his customers file claims when PCO collapsed. He further asserts that he had concluded in good faith from the bulletin issued by All American that he could sell viatical products as long as he did not do so through All American and abided by the restrictions in that bulletin. The NASD considered these factors when it sanctioned Devine.38

Recognizing the seriousness of selling away, the NASD guidelines for violations of Rule 3040 provide for a fine of up to $50,000 and a suspension of up to two years, or "in egregious cases," a bar.39 Devine's sanctions are at the low end of the guidelines.

In light of all of these factors and our review of the record, we find that the sanctions imposed on Devine were neither excessive nor oppressive.

Conduct Rule 3040 prohibits any person associated with a member firm from participating in any manner in a private securities transaction outside the regular course or scope of his employment without providing prior written notice to the member. Such notice must describe in detail the proposed transaction and the person's proposed role in it. The notice must also state whether the associated person has received or may receive selling compensation in connection with the transaction. If the associated person will receive compensation, the person must receive written approval from the member firm.

Conduct Rule 2110 requires that members and associated persons "observe high standards of commercial honor and just and equitable principles of trade."

The All American Life Insurance Company is philosophically opposed to the use of viatical settlements. We believe that accelerated death benefit provisions are a better method of achieving this end, and can do so at less cost to the policyholder. As you and your producers are independent contractors, we would not dictate to you how to conduct your business, except as it affects our company. In that regard the following restrictions apply to any agent of All American Life Insurance Company:

The agent may not solicit insureds of our company for viatical settlements.

In no manner or form can it appear that All American Life Insurance Company is sponsoring the use of viatical settlements.

The agent cannot advertise any affiliation with All American Life Insurance Company in the course of doing viatical settlements.

Any breach of these guidelines violates the General Agent Agreement and is cause for termination.

Each PCO lender was required to sign a statement that the "loan transaction is not an investment as defined by the Securities and Exchange Commission . . . ." The lenders were further required to assert that the "loan transaction is not to be considered a public offering, stock option, private placement or limited partnership" and that they were not acting with PCO as a "partnership, joint venture or syndicate in any manner whatsoever," but, rather, "all parties are acting independently of each other."

The opinion letter stated, "under the authority of the Life Partners case, there is no question and it is my opinion that the transaction as structured is not the sale of securities, and thus does not violate such law."

None of Devine's PCO investors were customers of U.S. Life Equity or All American. Devine asserts that the five customers had high net worth and were experienced investors, particularly with commercial loans.

On September 18, 1998, Laing pleaded guilty to securities fraud and mail fraud and was sentenced to 96 months in prison and ordered to pay restitution. See United States v. David Laing, No. 97-0638 (S.D.N.Y. Sept. 18, 1998).

On November 13, 1997, the Commission filed a complaint in the Southern District of New York alleging that Laing and PCO "fraudulently raised approximately $95 million from investors nationwide by offering and selling securities in the form of investments in a loan program offered by PCO." The complaint further alleged that Laing and PCO "falsely represented that they would use the proceeds of the sales of the PCO Loan Program to make investments in viatical settlements . . . . [and that Laing and PCO] misappropriated and otherwise misused the proceeds of the offering." On February 17, 1999, the Court entered a final consent judgment in which Laing was enjoined from violations of Sections 5(a), 5(c), and 17(a) of the Securities Act of 1933, and Section 10(b) of the Securities Exchange Act of 1934 and Exchange Act Rule 10b-5.

In April 1997, at the request of the California Department of Corporations, the Los Angeles Superior Court appointed a receiver to oversee investor claims for reimbursement from PCO and its principals.

On May 17, 2001, the NASD issued an opinion finding that Devine, Fergus, and Blake had violated NASD Conduct Rules 3040 and 2110. The NASD fined Fergus $8,000, suspended him for 60 days from associating with a member firm in any capacity, and required him to requalify by examination as an investment company and variable contracts products representative prior to acting in any capacity requiring that registration. The NASD fined Blake $35,000, suspended him for 180 days, and required him to requalify by examination. Neither Fergus nor Blake appealed the NASD's decision.

Reves v. Ernst & Young, 494 U.S. 56, 60-61 (1990) ("Congress' purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.").

If the seller's purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a "security."

Id. at 66 ("The Court will consider instruments to be 'securities' on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not 'securities' as used in that transaction.").

Examples of notes that are not securities include: notes delivered in consumer financing, notes secured by a home mortgage, short-term notes secured by a lien on a small business or some of its assets, or secured by an assignment of accounts receivable, and notes evidencing a loan by a commercial bank for current operations. Id. at 65; Banco Espanol de Credito v. Security Pacific National Bank, 973 F.2d 51, 56; Gerald James Stoiber, 53 S.E.C. 171, 175 n.9, petition denied, 161 F.3d 745 (D.C. Cir. 1998).

Another form of the Escrow Agreement states that Laing "irrevocably assigns the insurance carrier [sic] to pay beneficiary proceeds to" Escrow Plus. However, there is no evidence of consent by any carrier to the purported assignment.

Even if we were to conclude that this factor were absent, its absence does not "add much to the inquiry into whether the promissory notes are securities. The Supreme Court itself described this factor as a one-way ratchet . . . . It allows notes that would not be deemed securities under a balancing of the other three factors nonetheless to be treated as securities if the public has been led to believe they are. It does not, however, allow notes which under the other factors would be deemed securities to escape the reach of regulatory laws." Stoiber, 161 F.3d at 751 (citation omitted).

Blake and Fergus also characterized the PCO notes as investments during their testimony. Blake described the notes as having "less risk for a comparable return for a pretty good year in the stock market." Fergus testified that the notes offered the lenders a "good opportunity for them to get a good rate of return without stock market risk."

In a document entitled "Frequently Asked Questions" ("FAQ") that PCO furnished to its prospective investors, PCO stated that its investment product differed from other viatical contracts. PCO noted that, while other companies make the investor "a partner in the policy," PCO, in contrast, provides that the "[l]ender is never a partner in the policy."

The FAQ also emphasized that, with other companies, the "[i]nvestor's interest varies with [the] time of [the] seller's death." With PCO, in contrast, "[e]ach lender is guaranteed a 25% interest per annum." PCO answered the question "Why can't I be the beneficiary on the Policy?" as follows: "If you're tied to one single policy, you would be tied to that seller. If the seller exceeds life expectancy this could limit your payoff. PCO pays its Lenders from a fund of beneficiary proceeds from the pooled policies which ensures timely repayment of the loan."

The NASD calculated the amount of the fine by adding the amount Devine had retained in commissions from his purported improper sales activities ($9,825.42), after paying a portion of his commissions ($9,836.50) to a court-appointed receiver, to the amount ($25,000) that the NASD determined he should be fined for violating the NASD Conduct Rules. Devine asserts that a fine of up to $10,000 is appropriate.

We do not agree with the NASD that the All American bulletin reasonably led Devine to conclude that he did not need to give notice to U.S. Life Equity. The fact that the insurance subsidiary did not prohibit its independent agents from engaging in the offer and sale of viatical programs (other than to its customers) was not relevant to Devine's obligation to contact U.S. Life Equity. U.S. Life Equity had made clear in its supervisory materials that it wanted prior written notice of potential securities transactions. Given the limitations on our role with respect to NASD sanctions, we do not find any basis to reduce Devine's sanction further.

Devine argues that the sanctions imposed on him are more severe than those imposed in similar cases. We consistently have held that the appropriate sanctions in a case depend on its particular facts and circumstances and cannot be determined by comparison with action taken in other cases. A.S. Goldman & Co., Inc., Exchange Act Rel. No. 44328 (May 21, 2001), 75 SEC Docket 49, 69 n.53. See also Butz v. Glover Livestock Commission Co. Inc., 411 U.S. 182, 187 (1973).